The US generic drug market has been quite lucrative for EM pharma companies over the last decade. Many EM pharma companies have significantly outperformed the market by leveraging solid technological capabilities and low manufacturing costs. However, the future looks more difficult as a number of changes in the US market have made the landscape increasingly challenging.
In the past, when there were fewer players in the market, the first few firms to launch a generic drug were able to generate profits for a longer period of time before they were overwhelmed by competition. This period has grown shorter as the number of generic companies has steadily risen. The market has become more fragmented, which has served to increase competition and pricing pressure (Exhibit 1).
Exhibit 1: Number of generic pharmaceutical companies
Second, pharmacy benefit managers (PBMs) have increased their size and negotiating power through consolidation. (PBMs process prescriptions and negotiate drug prices with pharma companies.) They are using their increased size to extract lower prices from drug manufacturers, which has further accelerated drug price erosion.
Third, the FDA has recently intensified its inspections on overseas drug companies. This has resulted in numerous observations and warning letters. In the best case, these actions result in higher spending on remediation measures. In the worst case, they can result in a halt on new drug approvals and supply restrictions. These events are notoriously difficult to forecast and often result in large drawdowns when the news comes out.
Finally, the number of drugs going off patent is declining (Exhibit 2). This means there will be more companies competing over a smaller profit pool. Additionally, a large number of future patent expirations will be biologic drugs, which are substantially more difficult and expensive to develop.
Exhibit 2: Generic expiries
In response to these challenges, many companies are trying to move up the value chain to sell complex generics, biosimilars, and even innovative drugs. While this strategy gives management a compelling story to tell and offers the potential for high future profits, we are skeptical that most EM companies will successfully make this transition. These types of drugs are significantly more challenging to bring to the market and many companies lack the technical expertise or capital to succeed (Exhibit 3). We also have seen many companies resorting to expensive acquisitions to bolster their pipelines. This can be effective but a misjudged acquisition can quickly destroy shareholder value. We have heard from multiple companies that it is increasingly difficult to find attractively priced acquisitions.
Exhibit 3: Current typical R&D spend per molecule
Source: UBS estimates
To borrow an overused expression, there is no longer a rising tide to lift all boats. The US generic market is increasingly competitive and difficult to operate in. EM pharma companies will have to spend largely and wisely on R&D and be extra diligent when evaluating M&A opportunities. Regulatory compliance is an omnipresent risk that requires strong process controls and strict attention to detail. EM pharma stocks still offer the potential for attractive structural growth. However, given the challenges the industry faces, we believe that investing in EM pharma companies increasingly requires a high degree of scrutiny to identify differentiated companies while avoiding the pretenders.
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